Business firms, whether operating domestically or internationally, are certainly exposed to risks of unfavourable movements in their profits resulting from unexpected movements in exchange rates. Fluctuation of exchange rates gives rise to foreign exchange exposure and foreign exchange risk. Nevertheless, these terms are often used interchangeably, in actual they represent two different, yet closely related concepts.
Exposure alludes to the degree to which a company is contrived by exchange rate changes. In other words, it’s the sensitivity of the real home currency value of an asset, liability or an operating income to an unanticipated change in the exchange rate, assuming unanticipated changes in all other currencies as zero. It is calculated by regression. Exchange rate risk is defined as the changeability of a firm’s value due to undetermined changes in the rate of exchange. In other words the Variability of the domestic currency values of assets, liabilities, operating incomes due to unanticipated changes in exchange rate. It is calculated by variance or standard deviation.
Foreign Exchange Risk & Exposure is classified into;
- Transaction Exposure,
- Translation Exposure (Accounting Exposure) and
- Operating Exposure (Economic Exposure).
Transaction exposure results from a firm taking on fixed cash flow foreign currency denominated contractual agreement. For instance, if a firm has entered into a contract to sell computers to a foreign customer at a fixed price denominated in foreign currency, then the firm would be revealed to exchange rate fluctuations till it receives the payment and converts the receipts into the domestic currency.
Translation exposure is also called accounting exposure, results from the need to restate foreign subsidiaries financial statements, usually stated in foreign currency, into the parents’ reporting currency when preparing the consolidated financial statements. Although translation exposure may not affect a firm’s cash flows, it could have a decisive impact on a firm’s disclose earnings and therefore its stock price.
Operating exposure is also called economic exposure, results from changes in the amount of future operating cash flows caused by exchange rate change. Resulting in gains or losses determined by changes in the firm’s future competitive position and is real. Therefore the impact of operating exposure is on revenues and costs associated with future sales.
Foreign exchange risk is classified into;
- Financial Risk
- Political Risk
- Country Risk
Financial Risk refers to unexpected events in the country’s financial, economic, or business life. Examples of financial risks are currency risk, interest rate risk, inflation risk unexpected changes in the balance of payment etc.
Political Risk is the risk that a sovereign host government will unexpectedly change the rules of the game under which the businesses operate. Examples are expropriation risk, disruption in operations, protectionism, blockage of funds, loss of intellectual property rights etc.
Country Risk can be classified into Macro risk and Micro risk. Macro risks upshot all firms in a host country. Micro risks affect specific to an industry, firm or project in a country.
One can manage foreign exchange risk and exposure through risk management tools like hedging, forward contracts, currency futures, currency options, and currency arbitrage. Myforexeye provides access to state of the art advisory services on a single tap, by making it the most convenient technique to manage foreign exchange risk and exposure.
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